We use a new database of long-run stock, bond, bill, inflation, and currency returns to estimate the equity risk premium for 17 countries and a world index over a 106-year interval. Taking U.S. Treasury bills (government bonds) as the risk-free asset, the annualised equity premium for the world index was 4.7% (4.0%). We report the historical equity premium for each market in local currency and US dollars, and decompose the premium into dividend growth, multiple expansion, the dividend yield, and changes in the real exchange rate. We infer that investors expect a premium on the world index of around 3-3 1/2% on a geometric mean basis, or approximately 4 1/2-5% on an arithmetic basis.

This research investigates the persistence of investment risk across time horizon, a crucial issue in asset allocation decisions. Previous empirical results have focused mainly on US data and suffer from limited sample size in the analysis of long-horizon returns. Investigation of a long-term sample of thirty countries provides additional empirical evidence. The results are not reassuring. There is no evidence of long-term mean reversion in the expanded data sample. Downside risk is not reduced as the horizon lengthens. On the positive side, a globally diversified portfolio would have displayed much less downside risk than any single market.

In this paper we examine the correlation structure of the major world equity markets over 150 years. We find that correlations vary considerably through time and are highest during periods of economic and financial integration such as the late 19th and 20th centuries. Our analysis suggests that the diversification benefits to global investing are not constant, and that they are currently low compared to the rest of capital market history. We decompose the diversification benefits into two parts: a component that is due to variation in the average correlation across markets, and a component that is due to the variation in the investment opportunity set. There are periods, like the last two decades, in which the opportunity set expands dramatically, and the benefits to diversification are driven primarily by the existence of marginal markets. For other periods, such as the two decades following World War II, risk reduction is due to low correlations among the major national markets. From this, we infer that periods of globalization have both benefits and drawbacks for international investors. They expand the opportunity set, but diversification relies increasingly on investment in emerging markets.

Value stocks have higher returns than growth stocks in markets around the world. For 1975-95, the difference between the average returns on global portfolios of high and low book-to-market stocks is 7.60% per year, and value stocks outperform growth stocks in 12 of 13 major markets. An international CAPM cannot explain the value premium, but a two-factor model that includes a risk factor for relative distress captures the value premium in international returns.

An important decision facing retirement savers is how to allocate their savings across different assets. The decision includes the choice of how to divide investments between domestic and foreign holdings. This study uses return data from 1927-2005 to determine whether cross-border investing in the past would have been advantageous to retirement savers in eight large industrialized countries. For retirement savers in most countries, though not the United States, na�ve overseas investment strategies would also have reduced the risk of catastrophically poor investment performance. In all countries, retirement savers who selected a global portfolio allocation along the efficient frontier could obtain better average pensions with lower risk of very small pensions than savers who restrict their investments to the domestic stock and bond funds.

With a double-digit growth rate in total market capitalization over the last decade, emerging stocks are becoming an increasingly important investment category. Emerging market equities behave in a different way from equities traded on developed markets. In the literature, there is usually a consensus on at least four distinguishing factors of emerging market stock returns: (1) volatility is high, (2) correlations with developed market returns are low, (3) returns are predictable to a certain extent, (4) third and fourth moments matter. However, opinions differ about average attractiveness of realized returns in emerging markets, depending on the period studied, the region, and the methodologies.

This paper surveys the wide literature around marginal and expected moments of the distribution of emerging stock returns, It reviews literature findings in a structure per statistical moment. Then it examines the potential applicability of the CAPM in emerging markets. Finally, it exposes avenues for further research identified from the survey.

International equities currently account for about 50% of global market capitalization, representing a sizable opportunity beyond U.S. borders. Over the past 36 years, returns and volatility have been similar across developed markets. Over the same period, however, international stocks have served to diversify portfolios focused on U.S. equities, reducing average volatility. Despite the size and potential benefits of international markets, some U.S. investors have been slow to venture abroad. According to various market surveys, international equities represent only approximately 11% of the typical institutional plan sponsor portfolio. This relatively low allocation may reflect concern about the risks unique to international investing, including: (1) the perceived higher risk of foreign markets, (2) the impact of currency volatility, (3) increasing global correlations, (4) higher investment costs, or even (5) aversion to short-term underperformance relative to domestic markets. We weigh these risks against the potential benefits and conclude that:
1.International stocks should be included in a domestic portfolio.
2.Empirical and practical issues suggest a starting allocation to international stocks of 20%, with an upper limit based on the proportion of the global market they represent.

By blending theoretical and empirical approaches, we find that the
allocation of a portion of a portfolio?s international exposure to emerging markets stocks can enhance the portfolio?s long-term risk-adjusted returns. The benefit of such an allocation is the opportunity to increase a portfolio?s return while reducing its risk through diversification. However, the cycle of bull and bear markets, financial crises, and stock market booms and bubbles can break down the long-term case. Indeed, over certain short periods of time, investments in emerging markets have reduced a portfolio?s return while increasing its volatility. To decide on the appropriate allocation to emerging markets, investors must weigh their expectations of long-run risk-adjusted returns against the potential regret of their portfolios? underperforming benchmarks or peer-group averages over shorter investment horizons. We recommend that risk-tolerant investors allocate a small portion of their international stock investments to emerging markets.

A picture may be worth a thousand words.
Here is the efficient frontier for allocations between U.S. and International stocks.

70% U.S./30% International = highest return
80% U.S./20% International = lowest standard deviation
1% to 40% = International allocations that have historically increased return over an all U.S. portfolio without increasing standard deviation.

With the introduction of VFWIX All-World ex-US fund, many people seem to wonder whether they should choose VGTSX Total International or VFWIX. Here is an attempt to address frequently asked questions in a single topic so that people can point to this topic later.

- Tax efficient. Its dividends were 87.23% qualified in 2007. It is eligible for foreign tax credit. It's very unlikely to distribute capital gains in the event that a country (think South Korea) moves out of emerging markets and joins developed markets.
- The expense ratio (0.40%) is higher than that of VGTSX (0.27%) , but that's more or less offset by foreign tax credit, which is expected to be around 0.16%.
- Includes Canada.
- Vanguard might introduce Admiral Shares as the fund grows. To this date, Vanguard has never issued Admiral Shares for a fund of funds, which VGTSX is.
- 0.25% purchase fee, which goes into the fund.
- Vanguard is expected to lower the expense ratio as the fund grows. Historically, Vanguard has been good at reducing the expense ratio as the fund grows. (For example, check out the prospectus for VTSMX Total Stock Market.)

VGTSX

- Not as tax efficient as VFWIX. Its dividends are about 70% qualified. It is not eligible for foreign tax credit because IRS says that a fund of funds is not eligible. (Don't ask!)
- The expense ratio (0.27%) is lower than that of VFWIX (0.40%).
- Does not include Canada.

3. How much should I allocate to international?

That's a personal choice. According to the poll, most people on this forum allocate anywhere from 20% to 50% of stocks to international. Pick a number and stick to it.

If you would like to use history as a guide, see the chart above by Trev H. Notice that domestic/international=80/20 gives you the least volatility with a better return than 100/0. 60/40 gives you an even better return with roughly the same volatility as 100/0. If you go beyond 50/50, you get a lot of volatility for not much return.

4. What is foreign tax credit?

Foreign tax credit in our context is a refund of tax that Vanguard pays in foreign countries. When Vanguard distributes dividends, they are already reduced by tax paid in foreign countries. With foreign tax credit, you can get that amount back, but you still have to pay Federal income tax on the dividends before the foreign tax is paid. Sorry, foreign tax credit isn't free money.

5. I am running out of tax-advantaged room. Should I put VTSMX Total Stock Market or VFWIX in a taxable account?

In general, you want to put VFWIX in a taxable account so that you can get foreign tax credit, but your individual situation may be different.

6. Should I hold VFWIX in a taxable account for foreign tax credit even though I haven't max out my tax-advantaged account?

No, you should fill your tax-advantaged account first with VGTSX. The only exception may be a nondeductible IRA, but if you have a nondeductible IRA, you should have enough money to hire a decent accountant.

7. I have VGTSX in a taxable account. What should I do?

If you have loss in your VGTSX or a small amount of capital gains, you can sell it and buy VFWIX. Otherwise, you could direct new money, including distributions from VGTSX, into VFWIX. For simplicity, you should just stick with VGTSX because the difference is probably not significant enough to make up for the difference in capital gains from selling.

8. Wow, VFWIX has expense ratio of 0.40%? Should I buy VEU, the ETF version of VFWIX, to save on the expenses?

If you take the ETF route, you can avoid the 0.25% purchase fee and two-month redemption fee, but you will likely have to pay commission on the purchase and sale. In general, ETF shares may be a good choice if:

- you already have a brokerage account which has low commissions (no more than $10 or so),
- you are planning to invest in large lump sum(s), rather than small monthly contributions (which would incur a commission at every purchase),
- your brokerage allows for (free) reinvestment of fund distributions, and
- you can resist the temptation to trade the ETFs too often.

It's a great fund except that it does not have emerging markets or Canada. The combination of VTMGX and VEIEX Emerging Markets Stock Index should work just as well as VFWIX. If you wanted to, you can direct new money to VFWIX, but I don't think that would make a big difference. The combination of VTMGX and VEIEX is cheaper than VFWIX, but VEIEX distributes some non-qualified dividends.

Advanced Questions

1. What funds are available if I want to own Europe, Pacific, and emerging markets separately?

3. Both VGTSX and VFWIX appear to lack small-cap. What should I buy to fill that area?

Unfortunately, this is an area that Vanguard isn't good at. You might want to consider DLS and GWX. Search for "site:diehards.org DLS GWX" on Google. You get a lot of hits. If your 401(k) or 403(b) is administered by Vanguard, you might have access to VINEX International Explorer.

4. I'd like some value tilt. What options does Vanguard provide?

You might consider VTRIX International Value Fund. If you are interested in growth tilt, consider VWIGX International Growth Fund. Both of these are actively managed funds and thus often distribute capital gains. You might want to place them in a tax-advantaged account.

5. I heard enough about tax efficiency, qualified dividends, and all that. Show me some hard numbers!